Law from 2006 gives SEC scope to probe S&P

Speculation of a downgrade Friday should drive SEC review: onlookers

By

RonaldD. Orol

WASHINGTON (MarketWatch) — As observers call for a probe of insider trading from Standard & Poor’s decision to downgrade the U.S. credit rating, a little-known law from five years ago gives the Securities and Exchange Commission authority to do so.

Regulatory observers are focusing, partly, on a heavy trading volume and a major sell off of equity securities at one point on Friday, responding to speculation rampant in the markets that S&P was going to downgrade the U.S. debt later that day. S&P did, in fact, lower the U.S. government’s top-tier credit rating late that day a notch to AA+.

At issue, in part, is a 2006 statute — the Credit Rating Agency Reform Act — that says a credit rating agency could have its licence registration revoked if it leaked information about its pending downgrade decision before making that information publicly available. It also said that the rater must have policies and procedures to prevent such a disclosure.

“If it is true that they told hedge funds and briefed banks and told a few people ahead of everyone else that would appear to be a clear violation 2006 Act,” said Consumer Federation of America director Barbara Roper. “Credit rating agencies have to have polices to prevent the dissemination of pending rating action on the Internet.”

SEC spokeman John Nester declined to comment on whether the commission is conducting such an investigation. Treasury officials did not return calls for comment.

S&P spokeswoman Catherine Mathis said the rater has polices and procedures designed to “bring about compliance with applicable regulatory requirements as well as to direct the appropriate handling, use, and protection of confidential Information.”

Columbia Law School Professor John Coffee said that regulators should look for significant trading activity such as attempts to short Treasury securities, in the period immediately before the downgrade.

“I think any time you have major market movements like this you should see whether there is unusual trading before the public announcement,” Coffee said. “Once you find out who is trading in usual large volumes then you can look into whether they have associations with anyone at S&P.”

He said that in addition to a possible insider trading move by an S&P associate, it was possible that an official at the U.S. Treasury Department could have leaked the information. Treasury officials, he added, could have told lawmakers on Capitol Hill or others about the pending downgrade in an effort to further the agency’s efforts to convince S&P not to take action.

“If he is doing this for a purpose of his agency without personal financial gain, it may not be a fiduciary breach but it is an unorthodox move,” Coffee said.

Jacob Frenkel, a former SEC enforcement attorney and partner at Shulman Rogers Gandal Pordy & Ecker in Potomac, Md., said the SEC should also look at whether any U.S. government official who had knowledge of the pending downgrade either traded based on that information or conveyed it to others in exchange for some personal financial benefit.

“That could be insider trading and, at minimum an ethics violation,” Frenkel said.

He said it is entirely appropriate for the SEC to investigate in situations of major unusual market movements, such as the volatile trading on Friday. However, he added that the agency should also look carefully at trading in the week before the Friday downgrade.

He said the SEC’s Enforcement and Trading and Markets units as well as the agency’s Office of Compliance Inspections and Examinations will likely examine the situation.

Frenkel added that the OCI unit will examine the S&P, which is a unit of the McGraw-Hill Cos.
MHP, +0.00%
), to ensure its procedures are effective to stop such a leak.

“If information about a credit rating action did get out from the rating agency then, at minimum, it raises questions about whether that rater had adequate compliance controls and procedures in place as required under the securities laws.

However, John Jay, analyst at the Aite Group in Boston, said he wasn’t sold on the fact that someone at S&P told market participants that this is what’s going to happen.

“When a rumor start it doesn’t have to begin with a person explicitly whispering somewhere saying this is what we’re doing,” Jay said. “Some can argue that S&P had been signalling their thought process a couple weeks prior to the downgrade.”

The downgrade has been met by fury from the Obama administration, which said it discovered a $2 trillion error in S&P’s analysis of the budget situation over 10 years, but was unable to stop the agency from going ahead with the downgrade.

The Senate Banking Committee is gathering information and looking into S&P’s downgrade, according to a committee aide. Regulatory observers say the committee will likely bring S&P officials to testify before the panel and seek to have documents disclosed revealing more details about the process leading up to the downgrade.

“They want to establish a clear picture of what happened, the process and what considerations were made and how the final decision was made,” Roper said.

She added that the panel will likely conduct an analysis of how S&P conducted its review and whether there was a “rush to judgement” by the rater after the White House expressed concerns about the rating analysis.

Regulatory observers also note that regulators and legislators may want to exact retribution against Standard & Poor’s through policy-making action.

“If the government agencies are mad at the S&P, which you could easily imagine, that could give energy to do other things that make it a lot more hospitable for competitors of S&P to emerge,” said Alex Pollock, resident fellow at the American Enterprise Institute.

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